The Financial Group
We simplify all those essential financial decisions
THE EDUCATION SECTION   November 2016 A guide to Investment Risk & Return What   is   Risk?    Over   the   past   few   years,   ‘risk’   has   become   a   popular   term   in   the   context   of   investments.   This   is in   part   due   to   the   fact   that   the   2008   financial   crisis   showed   how   many   investors   were   unsure   or   unclear   about what   risks   they   had   been   taking   with   their   investments.   Before   2008   there   have   been   many   times   when uncertainty   has   arisen   –   eg:   9/11   of   2001   &   Black   Monday   of   1987.   The   word   risk,   even   within   the   narrow scope   of   investing,   can   be   viewed   in   many   different   ways.   One   distinction   we   can   make   is   between   investOR   risk  and investMENT risk . What   is   investor   risk?    Investor   risk   can   be   described   as   the   possibility   of   not   being   able   to   match   your   future outgoings with the savings pot you’ve accumulated for this purpose - eg: your pension fund. This   risk   is   managed   by   financial   advisers   when   they   gather   information   regarding   the   future   cash   flow requirements of a client, and advise accordingly. What   is   investment   risk?       ‘Investment   risk’   is   different   -   it   describes   the   fluctuations   in   value   of   a   portfolio over   time.   For   many   of   our   clients,   the   main   concern   is   loss   of   capital.   While   this   is   applicable   in   the   case   of highly   concentrated   investments   (such   as   a   few   stocks   or   shares)   it   is   less   applicable   in   the   case   of   a diversified   portfolio.   Here,   the   risk   of   total   loss   is   spread   across   each   of   a   large   number   of   investments.   This means   that   instead   of   looking   solely   at   potential   loss,   we   focus   on   the   predictability   of   expected   returns.   We measure this predictability using volatility. How do we work out the route forward?           The   starting   point   is   our   Risk   Questionnaire.   We   have put   together   a   range   of   questions,   together   with   our partners   FE   Analytics,   to   produce   a   report   that   we   use as   a   discussion   document   that   we   can   talk   through   with you     to     help     understand     your     thoughts     on     your investments   &   the   ‘risks’   that   you   are   happy   to   take   to achieve   your   goals.   None   of   the   answers   are   ‘set   in stone’.   They   &   the   report   just   help   you   &   us   enormously when we are discussing the best route forward. Click   the   Risk   Questionnaire    image   if   you   would   like   to   complete   our   Risk   Questionnaire   &   receive   a   report summarising your answers & our interpretaion of your Risk level. What   is   volatility?    Mathematically,   volatility   is   the   standard   deviation   of   annual   returns.   (Wow!   Need   an explanation?   Find   out   here .)   Under   normal   market   conditions,   this   describes   the   range   of   returns   around   the average you would expect to see in 2 years out of 3. Clearly,   these   past   few   years   have   shown   that   markets   don’t   always   behave   ‘normally’,   and   we   can   see   returns which are much higher or lower than expected. What   does   this   mean   for   you   as   an   investor?    There   is   a   need   to   find   a   balance   between   the   level   of predictability   you   wish   to   have   in   your   investment   return,   and   the   level   of   return   you   are   aiming   for.   There   is   of course   a   trade-off   to   be   made   here   -   asset   classes   with   highly   predictable   returns,   such   as   cash   or   gilts,   offer little   by   way   of   a   ‘premium’,   while   asset   classes   which   experience   greater   fluctuations,   such   as   equities,   can offer higher returns, but with less ability to predict whether or not you’ll achieve these higher levels. Managing   your   Investment   Risk.   Once   we   have   determined   the   level   of   predictability   you   wish   to   have,   the aim   of   investing   is   then   to   manage   this   as   efficiently   as   possible.   In   other   words,   to   maximise   your   potential return while maintaining the same level of predictability about that return. There are 2 tools that are effective in achieving this - diversification  and compounding . Diversification.    Bond    prices,   which   benefit   from   falling   interest   rates   and   fear   in   equity   markets,   often rise   while   equities   are   falling,   and   this   low   correlation   can   reduce   the   overall   portfolio   volatility   without materially   impacting   the   expected   return.   This   effect   can   become   amplified   when   you   begin   to   introduce alternative asset classes such as property or commodities. A   balanced   portfolio,   comprising   of   equities,   bonds   and   alternatives,   should   therefore   produce   superior returns per unit volatility compared with the individual asset classes. Compounding    -   refers   to   holding   an   investment   for   a   longer period    of    time,    meaning    there’s    a    greater    likelihood    of achieving   the   expected   annual   return.   By   increasing   the amount   of   time   that   the   investment   is   held   for,   the   impact of annual variation in portfolio returns can be minimised. The   chart   on   the   right   shows   the   maximum   and   minimum annualised   real   returns   of   UK   equities   since   1985,   showing how     the     return     on     an     investment     becomes     more predictable as the time horizon increases. The   average   annual   return   realised   over   this   timeframe doesn’t   really   differ   and   sits   at   around   7%   per   annum,   but holding   the   investment   for   10   years   rather   than   1,   3,   or   5 years   significantly   increases   the   likelihood   of   realising   the expected annual return. As always, please do not hesitate to contact us  if you would like further details or information.